THE WEST RISKS COLLATERAL DAMAGE BY PUNISHING RUSSIA / THE FINANCIAL TIMS COMMENT & ANALYSIS

July 27, 2014 5:50 pm

The west risks collateral damage by punishing Russia

By Wolfgang Münchau

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If you want to know how sanctions will affect the global economy, it is best to follow the money

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When I read last week’s revision in the International Monetary Fund’s forecasts, I was reminded of William Gilmore Simms, a 19th century US historian, who said: “I believe that economists put decimal points in their forecasts to show that they have a sense of humour.”

If only that were true. The latest update of the IMF’s World Economic Outlook puzzled me in two decimal-point respects, neither of them humorous.

The first is a downward revision of Russian economic growth by only 1.1 per cent for 2014 to a still positive growth rate of 0.2 per cent. In other words, the annexation of Crimea, the recent escalation of Russia’s proxy war in eastern Ukraine and the west’s reaction have had little economic effect. Really?

Forecasters have a hard time putting shocks – including sanctions – that are hard to measure into their models. We know the large-scale economic forecasting models used by international institutions perform badly during and after financial crises. In a situation like this, they are hopeless. The correct answer on the question of Russian growth is not “0.2 per cent” or some other number. It is “Don’t know”. For example, nobody could have known that the Russian central bank would raise the main interest rate on Friday to 8 per cent.

My second surprise is closely related. The IMF raised the German growth forecast for 2014 from 1.7 per cent to 1.9 per cent. I am not saying this is wrong. But can we be sure Germany will brush off sanctions against Russia so easily – especially, as is now likely, if the EU this week widens them to the financial sector?

The sanctions to be decided this week are known in EU jargon as “tier three”; the red-alert stage. As reported by Peter Spiegel, the Financial Times Brussels bureau chief, the European Commission wants a ban on purchases by EU citizens and companies of equity and debt issued by state-controlled Russian banks that has a maturity of more than 90 days. 

The ban would also include investment services. No EU bank would be allowed to help Russians banks raise funds on a regulated market. The rule would extend to development finance institutions. 

Last week, the EU and the US used their majority vote on the board of the European Bank for Reconstruction and Development to stop the bank’s investments in Russia, which accounts for almost 20 per cent of its invested assets.

With the US sanctions, this is an impressive list. Even the tier one and tier two measures introduced after the annexation of Crimea appear to have had an impact. German industrial production started to fall soon after those sanctions took effect, by a combined 2 per cent in April and May. It has also gone down elsewhere in the eurozone.

The Committee on eastern European Economic Relations, a German business lobby with political power similar to that of the National Rifle Association in the US, says existing sanctions threaten 25,000 German jobs. An estimated 350,000 German jobs directly depend on German-Russian trade; many would be at risk if sanctions were stepped up. Total German trade with Russia was close to €80bn in 2013.

In particular, there are 6,200 Russian companies benefiting from German capital. Robert Kahn from the Council on Foreign Relations in the US wrote in May that the impact of Russian sanctions on the global economy would depend on the financial channels that link Russia to the west. He notes that much of the public discussion has focused on critical trade ties. 

The implication is that, if you want to know how sanctions filter through to the global economy, it is probably best to follow the money not the flow of gas, oil or, indeed, helicopter carriers. Just as finance acted as a growth accelerator before the economic crisis, financial sanctions could act as decelerator.

In terms of how the sanctions will affect the west more broadly, Francesco Papadia, formerly at the European Central Bank, has estimated in a recent article that the impact on the EU will be about two-thirds higher than on the US. The effect on Russia is going to be much stronger, although possibly not right away. According to the Central Bank of Russia, the country’s foreign exchange reserves had a market value of $478bn at the end of June, a large but finite buffer.

Most of that is presumably held in dollars and euros – and, since they are not held in cash but in bonds or other securities, they would have to be channelled through payment systems in the US and the EU to be usable.

Depending on how the sanctions are drawn up, those reserves may prove hard to mobilise if the EU and the US were to engage in all-out financial warfare.

We are a long way away from that. But even the current list of sanctions could be macroeconomically significant in a way not captured by forecasts or sentiment surveys. My guess is that the cumulative global effect of the sanctions will be much stronger than estimated but that it might be a while before they kick in fully.

In short: we should not see this as a decimal point disturbance.

Copyright The Financial Times Limited 2014.